Why Annuities Won't Fix The Retirement Problem

Last Updated Jun 29, 2010 10:31 AM EDT

There's been a lot of talk lately about the failure of the 401(k) plan and the retirement system in general. The solution being pushed by the Obama administration and others is to convert people's retirement savings into annuities that provide lifetime income. Sounds good, but it doesn't solve anything.

Why? Because the income an annuity will produce is directly related to the amount of money you put into the annuity. So if you don't have much money saved for retirement, you won't get much of an income stream from an annuity. And most people don't have much money saved for retirement.

Here's a basic example of how annuities work:

Let's say you and your spouse are age 65 and ready to retire. You want to buy one of these annuities you've heard about. So you go to get an annuity quote, which will tell you how much income you can produce for each dollar you contribute to the annuity.
  • The type of annuity I am talking about is something called a life-only, immediate annuity, and is the traditional form of an annuity. It's similar to the payments you might receive from a traditional pension plan.
  • An annuity is basically a contract with an insurance company that says, if you give us $X of money, we'll pay you $X of income for the rest of your life.
At today's interest rates, you'll get about $5.85 of income per year for every $100 you contribute to the annuity (based on a recent quote from a highly-rated insurer). And this $5.85 would be paid to you and your spouse for as long as you both live. That's basically a 5.85% payout on your savings in retirement.

So if you've saved $100,000 for retirement, your retirement income will be $5,850 a year. Now, if you saved $1,000,000 for retirement, you'd have $58,500 a year for as long as you live.

In both situations, however, you also must deal with inflation. These annuity payments don't increase and are fixed for life. So if inflation runs at 3% a year (the average for the last 80 years), your retirement income will be cut by about 45% by the time you're 85. Meaning that the $5,850 of income will buy you about $3,220 of stuff in today's dollars, and the $58,500 will buy you about $32,200.

You can buy an inflation-adjusted annuity, but when you do that, your initial payout goes down to somewhere around 4% of the money you put into the annuity. Why? Because the insurance company knows it has to increase the payments each year for inflation, so it simply reduces what it pays you when the annuity starts.
  • As you can see, there's no magic money available from annuities. What you put in is directly related to what you get out, and the payment streams are pretty modest, especially when you factor in inflation, which is the biggest risk to fixed income investors.
  • Moreover, with an annuity, you lose access to your money. Essentially, you gave your money to the insurance company to purchase the annuity. It's theirs to keep forever, and your income is dependent on the insurance executives running a sound insurance company for the next 30 or so years. That's always hard to predict and carries it's own risks.
What concerns me about the current push for annuities is that they're being presented as some sort of miracle fix for the retirement crisis. The annuity talk is for the most part a red herring. The problem is a national lack of savings, not a lack of income producing investment options (such as annuities).
  • And the real issue with annuities is who gets to own and control your life's savings. It's an important issue, and I'll cover that in a later post.
The only way to create meaningful retirement security is to make sure people save more. That means less consumer spending and more investing. It's not the type of thing that's great for the economy today, and it's not really the message most people want to hear.

Over the last decade, Americans have saved between 0% and 4% of their income. There's no way the average American can retire when they don't save any money. It's just that simple. The savings rate needs to be between 10% and 15% to give people any reasonable hope of building retirement security.

Bottom line. Make sure you save a ton of money for retirement. There's no substitute for a big portfolio.

Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my new book Your Money Ratios: 8 Simple Tools For Financial Security, available in bookstores and at amazon.com The Wall Street Journal called the book "one of the best finance books to cross our desks this year." WSJ 12/19/09.
  • Charlie Farrell

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